Real estate stocks’ run may be near an end

Talk about climbing a wall of worry. Real estate investment trusts have doubled since early March despite persistent warnings from the Federal Reserve and economists that commercial real estate could be the next big shoe to drop in the financial crisis after the residential housing bust.

During the market’s seven-month climb, riskier sectors that fell the hardest during the sell-off have posted the sharpest gains, and that’s certainly been the case for REITs. The group, which gives individual investors a way to participate in commercial real estate sectors such as offices and apartments, has risen 30 percent over the past three months.

Many Wall Street analysts say the sector has climbed too far, too fast. REITs face multiple economic headwinds as the U.S. tries to shake off the recession. The market for commercial mortgage-backed securities is in shambles, rents and occupancies are weakening, and tenants are feeling the chill of the economic downdraft. Property values are down, and delinquencies and defaults are rising.

Mall giant General Growth Properties Inc. was forced to file for bankruptcy in April when it couldn’t refinance its crushing debt load.

“We have a cautious outlook on the space, as the recent sector rally is ahead of fundamentals — we expect further economic headlines that will pressure shares,” said Stifel Nicolaus & Co. analysts.

On the positive side, some of the stronger companies have even been able to tap the markets for fresh capital during the rally, and dividend yields are attracting some income-hungry investors.

Many REITs, though, have been forced to slash dividends during the market carnage, and some have resorted to paying out stock rather than cash. But Stifel thinks the sector’s yield has bottomed out.

“REITs have bolstered their balance sheets, as the capital markets began to thaw in March,” the analysts said, adding the sector has completed nearly 60 equity raises since the middle of March, improving the survival odds for overlevered REITs. “Some issuances were purely defensive and destroyed shareholder net asset value, and will weigh on future earnings growth.”

The outlook for commercial real estate remains bleak and the Fed has been trying to prop up the market for commercial mortgage-backed securities. Federal Reserve Chairman Ben Bernanke has been warning that defaults in commercial real estate are one of the most serious challenges facing the U.S. economy.

REITs were one of the hardest-hit industries when credit markets went into cardiac arrest last year, and the sector is closely tied to the health of the overall economy.

Despite the recent bounce, the SPDR Dow Jones REIT ETF was still off 29 percent for the year ended Sept. 30. The exchange-traded fund was lagging the S&P 500 Index by nearly 22 percentage points, according to investment researcher Morningstar.

The ETF’s top holdings are bellwethers such as Simon Property Group Inc., Vornado Realty Trust, Public Storage Inc., Boston Properties Inc. and Equity Residential. The fund’s dividend yield currently tops 4 percent.

“The credit crisis, in particular, has shaken the foundation of REITs,” said Morningstar analyst Scott Burns in a profile of the fund. He said the companies are “highly leveraged and have little cash on hand” because they’re required to pay out at least 90 percent of their annual earnings to shareholders as dividends.

“REITs are currently enduring the perfect storm: a lack of credit and weak economic fundamentals,” Burns said. “Even lenders who have the capacity to make loans are skittish to do so, given worsening economic fundamentals and deflating asset values.”

Late 2008 and early 2009 was simply a disaster for REITs as the companies found themselves shut out of capital markets — the sector lost a third of its value in the first quarter of 2009 alone.

Although companies with stronger balance sheets fared relatively better, that trend reversed in the second quarter as investors regained their appetite for riskier assets.

The “thawing” of the equity capital markets for REITs has altered the landscape, with significant outperformance “by some of the most highly leveraged REITs,” said Keefe Bruyette & Woods analyst Sheila McGrath.

The performance leaders since the market bottom on March 9 have been the more speculative names such as Developers Diversified Realty Corp. (DDR), SL Green Realty Corp., CBL & Associates Properties Inc. and Macerich Co.

“What a difference a year makes,” McGrath said. “The names on the leaders’ board since the REIT trough in March and year-to-date include many contrarian plays in 2009 — lodging, malls, developers and highly leveraged REITs — the proverbial basket of what conventional wisdom or the consensus avoided.”

Meanwhile, the analyst noted the laggards during the rally included health-care REITs and companies with strong balance sheets, which were viewed as safer. “The equity capital markets opening up to public real estate companies did surprise the markets and the rules of the game changed.”

Some analysts tracking the REIT sector are advising investors to take the money and run after the powerful rally.

Although fundamentals have not yet stabilized, investor psychology has, said analysts at BMO Capital Markets.

“The question is whether or not the resulting rise in REIT shares is premature, which we will learn with hindsight in the coming quarters,” BMO said in a Sept. 23 report to clients.

The analysts said it was “prudent” to take a step back from REITs and lowered their sector rating to market perform from outperform.

“The REITs’ stunning round trip this year has reached a point where we now believe that valuations are reasonable, reflecting both weak fundamentals and improving capital markets,” BMO said.

“It is possible that momentum investors will fuel some additional upside,” it added. “But we are content to book the healthy gain, while still on the lookout for names that could provide above-average returns from here.”

BMO’s top-rated stocks in the multifamily sector are Camden Property Trust, Home Properties Inc. and UDR Inc. It also likes Douglas Emmett Inc. in the office space, as well as Health Care REIT Inc., which specializes in assisted-living and medical-office facilities.

Even though the REIT rally has been impressive in percentage terms, the sector is still well below its 2007 peak.

“Depending on the property sector, we believe the recovery of fundamentals is between nine and 18 months away. We believe the recovery in REIT stocks over the past several months is mainly a function of the ‘going concern’ question being put to rest,” BMO said.

“As for whether the recovery in stock prices has overshot its mark, we are in the camp of the industry being fairly valued now, and anticipate a pause in stock price appreciation for now as the fundamental recovery gains firmer footing,” the analysts noted.

Investors will be closely watching REITs’ third-quarter earnings for any signs of fundamental improvement.

David Shapiro at BGB Securities is taking a cautious stance on REITs even though the shares are reflecting a healthy economic recovery.

“We continue to believe the economic recovery will be weaker than previous recoveries on a GDP and employment-growth basis and that credit will remain tighter than previous expansion cycles,” he said.

“We remain bearish on REITs in the short-term given the steep increases in share prices without a significant improvement in the secured debt markets or vacancy outlook,” he said.

Shapiro favors REITs with conservative balance sheets, “although much of the upside potential in these names is limited given the tremendous run-up in equity valuations.”

Jeffrey Rogers, president of Integra Realty Resources Inc., in an interview said his longer-term view on REITs is subdued. “Interest rates will start to increase once the Fed stops purchasing debt,” he said.

Other hurdles include higher tax rates as a result of government spending, massive amounts of mortgage debt coming due, and pressure on dividends.

“The economy is still negative,” he said. “All of the metrics that drive demand for real estate are trending in the wrong direction. Unemployment will hit double digits, incomes are coming down and people are increasing their savings because they don’t feel wealthy.”

He said the market for commercial mortgage-backed securities, which was a huge factor in pushing up real estate prices, is virtually gone. He thinks REIT earnings will fall 5 percent next year as cash flows continue to deteriorate.

Yet he said there are many REITs that are planning initial public offerings to take advantage of distressed property prices. They should be able to raise fresh capital and won’t be saddled with troubled assets on their books.

“They will be more attractive,” Rogers said. “They’ll be going public into one of the best times to buy distressed commercial real estate in years.”